Fiscal Policy

How much spending does it take?

Introduction

• http://www.youtube.com/watch?v=1qhJPqyJRo8&feature=plcp&context=C49f6c9cVDvjVQa1PpcFMdkWSNt1EsUKtB5fYByDq14YICcdVaANI%3D

What is FISCAL Policy?

Fiscal Policy Spending – where does it all go?

• http://www.nytimes.com/interactive/2012/02/13/us/politics/2013-budget-proposal-graphic.html

HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND

• Fiscal policy – taxing, spending, and borrowing• influences saving, investment, and growth in the

long run.• In the short run, fiscal policy primarily affects the

aggregate demand.

• What are challenges to fiscal policy implementation?

Changes in Government Purchases

• There are two macroeconomic effects from the change in government purchases: – The multiplier effect– The crowding-out effect

http://www.youtube.com/watch?v=H3nyc8XHrQc

The Multiplier Effect

• Government purchases are said to have a multiplier effect on aggregate demand.– Each dollar spent by the government can raise the

aggregate demand for goods and services by more than a dollar.

Figure 4 The Multiplier Effect

Quantity ofOutput

PriceLevel

0

Aggregate demand, AD1

$20 billion

AD2

AD3

1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .

2. . . . but the multipliereffect can amplify theshift in aggregatedemand.

A Formula for the Spending Multiplier

• The formula for the multiplier is:– Multiplier = 1/(1 – MPC)– An important number in this formula is the

marginal propensity to consume (MPC).• It is the fraction of extra income that a household

consumes rather than saves.

A Formula for the Spending Multiplier

• If the MPC = 3/4, then the multiplier will be:Multiplier = 1/(1 – 3/4) = 4

• In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

The Crowding-Out Effect

• Fiscal policy may not affect the economy as strongly as predicted by the multiplier.

• An increase in government purchases causes the interest rate to rise.

• What are the consequences of a higer interest rate?

The Crowding-Out Effect

• This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

• The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Figure 5 The Crowding-Out Effect

Quantityof Money

Quantity fixedby the Fed

0

InterestRate

r

Money demand, MD

Moneysupply

(a) The Money Market

3. . . . whichincreases

theequilibriuminterestrate . . .

2. . . . the increase inspending increasesmoney demand . . .

MD2

Quantityof Output

0

PriceLevel

Aggregate demand, AD1

(b) The Shift in Aggregate Demand

4. . . . which in turnpartly offsets theinitial increase inaggregate demand.

AD2

AD3

1. When an increase in government purchases increases aggregate

demand . . .

r2

$20 billion

http://www.youtube.com/watch?v=RGlt0nEQdRI&feature=plcp&context=C48ec1e6VDvjVQa1PpcFMdkWSNt1EsUByRZ_JiwOoaMf6ZO6WVkJM%3D

Changes in Taxes

• When the government cuts personal income taxes, it increases households’ take-home pay.

• Households save some of this additional income.

• Households also spend some of it on consumer goods.

• Increased household spending shifts the aggregate-demand curve to the right.

Changes in Taxes

• The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects.

• It is also determined by the households’ perceptions about the permanency of the tax change.

What are the Types of Taxes?

• Proportional Taxes• A tax with a constant % paid regardless of income• Flat tax

• Progressive Taxes• A tax where the % paid in taxes increases as income

increases• U.S. Personal Income Tax

• Regressive Taxes• The lower your income the higher % you pay in taxes• Sales Tax

Proportional, regressive, or progressive?

USING POLICY TO STABILIZE THE ECONOMY

• Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946, which states that:– “it is the continuing policy and responsibility of

the federal government to…promote full employment and production.”

The Case for Active Stabilization Policy

• The Employment Act has two implications:– The government should avoid being the cause of

economic fluctuations.– The government should respond to changes in the

private economy in order to stabilize aggregate demand.

– What economic school of thought does this follow? Who would be against active stablization?

The Case against Active Stabilization Policy

• Some economists argue that monetary and fiscal policy destabilizes the economy.

• Monetary and fiscal policy affect the economy with a substantial lag – rational expectations!!!

• They suggest the economy should be left to deal with the short-run fluctuations on its own.

Automatic Stabilizers

• Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

• Automatic stabilizers include the tax system and some forms of government spending.